What is the difference between a tax deduction and a tax credit?

A tax credit directly reduces the amount of tax owed, providing a dollar-for-dollar reduction in tax liability. For example, if you owe $1,000 in taxes and qualify for a $200 tax credit, your total tax payable would drop to $800. This makes tax credits very powerful since they provide a direct reduction in how much tax you have to pay.

On the other hand, a tax deduction lowers your taxable income, which can decrease the amount of tax you owe, but it does so indirectly. When you take a deduction, it reduces your income before calculating how much tax you owe. For instance, if your taxable income is $50,000 and you have a $1,000 deduction, your taxable income would be reduced to $49,000. The actual amount of tax savings you receive from a deduction depends on your tax bracket.

The distinction between these two concepts is crucial for taxpayers as it impacts their overall tax liability and the amount they may owe or receive in refunds. Understanding the nature of tax credits and deductions helps in effective tax planning and maximizing tax benefits.